How to Calculate Acid Test Ratio: Overview, Formula, and Example

 October 5, 2022
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It is worth remembering that the general rule says that the higher the quick ratio, the higher the company’s liquidity. Although most financial analysts agree that a quick ratio higher than 1.0 is acceptable, you should know that its optimal value depends on the branch of the industry. If you don’t have any internship or work experience that involved using the quick ratio, you can discuss any coursework or personal experiences with this calculation. For example, you can mention if you helped a family member’s or friend’s small business figure out their financial health. For example, the current ratio is great at giving high ratio scores for companies with large inventories. On the other hand, the quick ratio leans more conservatively, especially for inventory-reliant business models.

Quick assets are assets a company expects to convert to cash in 90 days or less. Current liabilities are obligations the company will need to pay within the next year. The quick ratio can provide a good snapshot of company’s health, but it can also miss important issues. For example, the ratio incorporates the difference between margin and markup accounts receivables as part of a company’s assets. This is important because leaving this information out can give a false impression, making the company seem financially weaker than it actually is. However, this depends on the company’s clients making their payments in a timely fashion.

  • Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.
  • Marketable securities are traded on an open market with a known price and readily available buyers.
  • Due to different characteristics, some industries may have an average quick ratio that seems high or low.
  • A quick ratio below 1 shows that a company may not be in a position to meet its current obligations because it has insufficient assets to be liquidated.

Ratios are tests of viability for business entities but do not give a complete picture of the business’s health. In contrast, if the business has negotiated fast payment or cash from customers, and long terms from suppliers, it may have a very low quick ratio and yet be very healthy. The higher your quick ratio, the better your business will be able to meet any short-term financial obligations. A quick ratio of 1 means that for every $1 in current liabilities, you have $1 in current assets.

How to Calculate the Quick Ratio: Example

A very high quick ratio, such as three or above, is not always a good thing. Small businesses are prone to unexpected financial hits that can disrupt cash flow. If there’s a cash shortage, you may have to dig into your personal funds to pay employees, lenders, and bills. It has short-term liabilities such as debt payment, payroll and inventory costs due within the next 12 months in a total amount of $40 million.

  • If there’s a cash shortage, you may have to dig into your personal funds to pay employees, lenders, and bills.
  • A quick ratio equal to 1.0 means that the value of a company’s assets that are precisely convertible to cash exactly match its current liabilities.
  • It would not be able to buy more inventory which would stop it from getting sales, halting the business operations entirely.
  • The quick ratio is thus considered to be more conservative than the current ratio since its calculation intentionally ignores more illiquid items like inventory.
  • Current liabilities are a company’s short-term debts due within one year or one operating cycle.

When compared to other tech companies, Facebook has the highest quick ratio. For the year ending 31st December 2018, ExxonMobil Quick ratio is 0.49 times which is almost similar to what the company reported in the previous period. For the year ended 3 February 2019, the Quick ratio for Home Depot is 0.22 times which is lower than 0.34 times that the company reported in the previous period. But, for the year ended 31 December 2018, Company’s current liabilities increased significantly relative to Quick Assets, hence there was a dip in the Quick ratio. To calculate the Quick ratio we need Quick assets and Current liabilities.

Current vs. Quick Ratio: An Overview

The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets. Walmart’s short-term liquidity worsened from 2021 to 2022, though it appears to have almost enough current assets to pay off current debts. A wide majority of current assets are not tied up in cash, as the quick ratio is substantially less than the current ratio. In addition, though its quick ratio only dropped a little, there are bigger changes in cash on hand versus the balances in accounts receivable. If a company’s financials don’t provide a breakdown of its quick assets, you can still calculate the quick ratio. You can subtract inventory and current prepaid assets from current assets, and divide that difference by current liabilities.

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A company that needs advance payments or allows only 30 days to the customers for payment will be in a better liquidity position than a company that gives 90 days. From the above calculation, it is clear that the short-term liquidity position of Reliance Industries is not good. Reliance Industries has 0.44 INR in quick assets for every 1 INR of current liabilities. The quick ratio of company XYZ is 1.2, which means company XYZ has $1.2 of quick assets to pay off $1 of its current liabilities.

The quick ratio may also be more appropriate for industries where inventory faces obsolescence. In fast-moving industries, a company’s warehouse of goods may quickly lose demand with consumers. In these cases, the company may not have had the chance to reduce the value of its inventory via a write-off, overstating what it thinks it may receive due to outdated market expectations. Marketable securities, are usually free from such time-bound dependencies.

Firms with a ratio of less than 1 are short on liquid assets to pay their current debt obligations or bills and should, therefore, be treated with caution. While the quick ratio is a quick & easy method of determining the company’s liquidity position, diligence must be done in interpreting the numbers. To get the complete picture, it is always better to break down the analysis and see the reason for the high quick ratio. Companies with relatively high quick assets will always manage to convert such assets into cash and pay off the current liabilities without any difficulty. Short-term investments or marketable securities include trading securities and available for sale securities that can easily be converted into cash within the next 90 days.

We have calculated the Quick ratio for various tech-based companies like Facebook, Microsoft and Google. For the year ended 31 January 2019, the Quick ratio for Walmart is 0.18 times compared to 0.15 times during the previous period. When we add all the Quick assets and Current liabilities for the respective companies we get below values.

This makes sure that the company has sufficient assets to pay off its quick liabilities. Hence, it is important to note that items like Inventories and Prepaid expenses which are often recorded as part of current assets are not to be considered. The benefit of lumping all debts together is it’s more accessible because people outside of the company may not have access to details like when a payment is due. On the other hand, counting only very immediate debts is ultimately more accurate but can be time-consuming and less applicable over a fiscal quarter or year. Accounts payable, or trade payables, reflect how much you owe suppliers and vendors for purchases.

It’s important to include multiple ratios in your analysis and compare each ratio with companies in the same industry. Liquidity corresponds with a company’s ability to immediately fulfill short-term obligations. Ratios like the acid test and current ratio help determine a firm’s liquidity. Solvency, although related, refers to a company’s ability to instead meet its long-term debts and other such obligations. Like other liquidity ratios, a ratio of 1 or above means the ratio indicates the company can meet its current liquidity needs.

Similar to the current ratio, which also compares current assets to current liabilities, the quick ratio is categorized as a liquidity ratio. If a company has a current ratio of less than one, it has fewer current assets than current liabilities. Creditors would consider the company a financial risk because it might not be able to easily pay down its short-term obligations. If a company has a current ratio of more than one, it is considered less of a risk because it could liquidate its current assets more easily to pay down short-term liabilities.

Analysis

The ideal liquidity ratio for your small business will balance a comfortable cash reserve with efficient working capital. A company may have a higher current ratio, especially if it carries a lot of inventory. Marketable securities are short-term assets that can take a few days to turn into cash. This means that the company owes more money in short-term liabilities than it has in cash, potentially indicating that the company cannot pay all of its bills in the coming months. For example, a quick ratio of 0.75 means that the company has or can raise 75 cents for every dollar it owes over the next 12 months.

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Therefore, the current ratio may more reasonably demonstrate what resources are available over the subsequent year compared to the upcoming 12 months of liabilities. Publicly traded companies generally report the quick ratio figure under the “Liquidity/Financial Health” heading in the “Key Ratios” section of their quarterly reports. In publication by the American Institute of Certified Public Accountants (AICPA), digital assets such as cryptocurrency or digital tokens may not be reported as cash or cash equivalents. Cash equivalents are often an extension of cash as this account often houses investments with very low risk and high liquidity. This value is over 1.0, indicating that Tesla has decent liquidity and should be able to cover its short-term obligations. The Quick ratio for Google over the past few years has been in the range of 4 times to 6 times which is relatively lower when compared with company like Facebook.

As evident from the chart above, when we look at the quick ratio for ExxonMobil, a US-based multinational & gas company, we can see the ratio is in the range of 0.4 to 0.5 times. This indicates the efficient management of the company’s Cash and Receivable balance relative to its current liabilities. When compared to both companies, Company A has a relatively strong liquidity position as against Company B whose Quick ratio is less than 1.

To calculate the quick ratio, we need the quick assets and current liabilities. For example, if a company has $1,000 in current liabilities on its balance sheet. But also has $1,500 in quick assets, so its quick ratio is 1.5, or $1,500 / $1,000.